Smart Directions 1.7.16 Understanding Global Markets
1.
2. Disclaimer
• Andreas Rauterkus is not a registered
investment advisor or broker/dealer. Readers
are advised that the material contained herein
should be used solely for informational
purposes. Andreas Rauterkus does not purport
to tell or suggest which investment securities
attendants should buy or sell for themselves.
You should always conduct your own research
and due diligence and obtain professional
advice before making any investment decision.
3. Objectives
• What is an exchange rate?
• Learn how the international monetary system
has evolved from the days of the gold
standard to today’s eclectic currency
arrangement
• Learn about exchange rate systems
• Examine how the euro, a single currency for
the European Union, was created
4. The Market for Currencies
• Foreign currency exchange rate is the price of
any one country’s currency in terms of another
country’s currency
• US Dollar ($ or USD) / European euro (€ or EUR)
exchange rate stated as “1.0743 dollars per
euro” or as $1.0743/€
• Most currency quotes follow a convention as a
result of some history or tradition
– E.g., euros per dollar and dollars per pound
6. Structure of the Foreign Exchange Market
• Geographically, the foreign exchange market
spans the globe with prices moving and
currencies trading every hour of every business
day
• Major world trading starts each morning in
Sydney and Tokyo
• Then moves west to Hong Kong and Singapore
• Continuing to Europe and finishing on the West
Coast of the U.S.
7. How to calculate exchanged value
• Exchange $100 into Euro
– Assume exchange rate equals $1.0743/€
– $100x $1.0743/€ = $2107.43/€, can’t use $/€
– Need €/$, thus 1/$1.0743/€ = €0.9308/$
– $100 x €0.9308/$ = €93.08
9. History of the International Monetary System
• The Gold Standard, 1876-1913
– Countries set par value for their currency in terms
of gold
– Exchange rates were in effect “fixed”
– Gold reserves were needed to back a currency’s
value
– The gold standard worked until the outbreak of
WWI, which interrupted trade flows and free
movement of gold
10. History of the International Monetary System
• The Inter-War years and WWII, 1914-1944
– During this period currencies were allowed to
fluctuate in terms of gold and each other
– Increasing fluctuations in currency values became
realized as speculators sold short weak currencies
– In 1934, the U.S. dollar was devalued to $35/oz
from $20.67/oz
– During WWII and its chaotic aftermath the US
dollar was the only major trading currency that
continued to be convertible
11. History of the International Monetary System
• Bretton Woods and the IMF, 1944
– Allied Powers met in Bretton Woods, NH and
created a post-war international monetary system
– The agreement established a US dollar based
monetary system and created the IMF and World
Bank
– Countries fixed their currencies in terms of gold but
were not required to exchange their currencies
– Only the US dollar remained convertible into gold
(at $35/oz with Central banks, not individuals)
– Devaluation was not to be used as a competitive
trade policy and up to a 10% devaluation was
allowed without formal approval from the IMF
12. History of the International Monetary System
• Fixed exchange rates, 1945-1973
– Bretton Woods and IMF worked well post WWII, but
diverging fiscal and monetary policies and external
shocks caused the system’s demise
• The US dollar remained the key to the web of
exchange rates
– Heavy capital outflows of dollars became required
to meet investors’ and deficit needs and eventually
created a lack of confidence in the US’ ability to
convert dollars to gold
13. History of the International Monetary System
– This lack of confidence forced President Nixon to
suspend official purchases or sales of gold on Aug.
15, 1971
– Exchange rates of most leading countries were
allowed to float in relation to the US dollar
– A year and a half later, the dollar came under
attack again and lost 10% of its value
– By early 1973 a fixed rate system no longer
seemed feasible and the dollar, along with the other
major currencies was allowed to float
14. History of the International Monetary System
• Floating Era, 1973-
– Exchange rates became much more
volatile and less predictable they were
during the “fixed” period
– Several emerging market currency crises
– EMS restructuring (1992) and introduction
of the Euro (1999)
16. IMF Classification of Currency Regimes
• Category 1: Hard Pegs
– Countries that have given up their own sovereignty over
monetary policy
– E.g. dollarization or currency unions
• Category 2: Soft Pegs
– AKA fixed exchange rates, with five subcategories of
classification
• Category 3: Floating Arrangements
– Mostly market driven, these may be free floating or floating with
occasional government intervention
• Category 4: Residual
– The remains of currency arrangements that don’t well fit the
previous categorizations
17. A Single Currency for Europe: The Euro
• In December 1991, the members of the
European Union met at Maastricht, the
Netherlands, to finalize a treaty that changed
Europe’s currency future.
• This treaty set out a timetable and a plan to
replace all individual EMS currencies with a
single currency called the euro.
18. A Single Currency for Europe: The Euro
• To prepare for the EMU, a convergence criteria
was laid out whereby each member country was
responsible for managing the following to a
specific level:
– Nominal inflation rates
– Long-term interest rates
– Fiscal deficits
– Government debt
• In addition, a strong central bank, called the
European Central Bank (ECB), was established in
Frankfurt, Germany.
19. • EMU initiated by 11 members in 1999 and
with 19 member states (out of 28 EU
members) by 2015.
– Most notable absentees: Denmark, Great Britain,
Sweden
• The euro affects markets in three ways:
– Cheaper transactions costs in the eurozone
– Currency risks and costs related to uncertainty are
reduced
– Price transparency and increased price-based
competition
A Single Currency for Europe: The Euro